Colorado Springs Technology must choose between two methods of producing a new p
ID: 2617166 • Letter: C
Question
Colorado Springs Technology must choose between two methods of producing a new
product. The initial costs and year-end cash flow are as follows:
Year
0
1
2
3
4
5
Method A
--$1,000,000
210,000
250,000
300,000
525,000
600,000
Method B
--$1,000,000
410,000
375,000
475,000
225,000
195,000
The company’s WACC is 10 percent. Calculate the NPV and IRR for each alternative.
What would be the future value of each project’s cash flows assuming the firm could reinvest cash flows at the IRR of each project?
What would be the future value of each project’s cash flows assuming the firm could reinvest cash flows at the firm’s WACC.
What is the present value of the future value (part c) using the WACC as the discount rate. What does this tell us in terms of reinvestment assumptions?
Year
0
1
2
3
4
5
Method A
--$1,000,000
210,000
250,000
300,000
525,000
600,000
Method B
--$1,000,000
410,000
375,000
475,000
225,000
195,000
Explanation / Answer
a. The company’s WACC is 10 percent. Calculate the NPV and IRR for each alternative.
b. What would be the future value of each project’s cash flows assuming the firm could reinvest cash flows at the IRR of each project?
c. What would be the future value of each project’s cash flows assuming the firm could reinvest cash flows at the firm’s WACC.
d. What is the present value of the future value (part c) using the WACC as the discount rate. What does this tell us in terms of reinvestment assumptions?
The present value of the future value using the WACC as the discount rate; NPV is negative for Method A and NPV is positive for Method B. While the future value was higher for Method A. Therefore if reinvested at WACC then method B is better.
Year (t) Method A PV of A@ 10% [Cash Flow/(1+10%)^t] Method B PV of B@ 10% [Cash Flow/(1+10%)^t] 0 ($1,000,000) ($1,000,000) ($1,000,000) ($1,000,000) 1 $210,000 $190,909 $410,000 $372,727 2 $250,000 $206,612 $375,000 $309,917 3 $300,000 $225,394 $475,000 $356,875 4 $525,000 $358,582 $225,000 $153,678 5 $600,000 $372,553 $195,000 $121,080 NPV (Sum of PVs) $354,049.96 $314,276.84 IRR 20.62% 23.21%